Sectornomics: Technology

Too many tech stocks have a defeatist outlook

J.P. Scandalios has barely gotten a wink of sleep over the past week. The Franklin Templeton Investments portfolio manager has been too stressed out by the tech sector's earnings season, which started on January 26 and ends this week.

"I should really buy some stock in Starbucks, because I'm subsisting on coffee," Scandalios said. The more important buying decision, though, is whether he can still recommend tech stocks to clients, and if so, where exactly within the sector is earnings potential moving up? Based on the slew of recently released earnings data, the answer to that isn't very straightforward.

Павел Игнатов | Getty Images

Scandalios has good reason to be nervous—the S&P 500 Information Technology sub-index has fallen by roughly 3 percent over the last week of trading. But tech earnings have been generally positive: As of last Friday, 31 tech companies had reported, and 27 of them had surprised to the upside, according to Franklin Templeton's data.

So what explains the softness in the sector? The revenue picture hasn't been as rosy, with only 56 percent of companies coming in above expectations. And investors have been spooked by something else in particular: numerous downward revisions to 2015 estimates.

IBM, Microsoft and Qualcomm are just some of the companies that have revised their outlooks. Of the 13 S&P 500 tech companies that have issued guidance since December 1, nine have since revised their fiscal year 2015 estimates downward, to below the mean EPS estimate, according to FactSet.

Qualcomm, one of the holdings in the Franklin Technology Fund, is down more than 10 percent since reporting on January 28, as a result of downgrading its 2015 earnings outlook by nearly $800 million.

"Most companies guided Q4 conservatively enough that they're beating or meeting estimates," Scandalios said. "But the guidance for Q1 is not being as well received. We haven't seen a lot of upward estimates—they've been more in line or down."

Where to place the blame

If tech investors need to blame something for the drop in their portfolio, they can direct their ire toward the rising American dollar. A number of companies, especially software operations, price their offerings in local currency, but their expenses are in greenbacks. As a result, when the U.S. dollar rises, that local currency translates into less money back home.

This is one reason why Google missed its targets. Google CFO Patrick Pichette said on its earnings call last week that that currency resulted in a negative impact of $468 million.

The currency headwinds are a big problem for tech stocks right now, said Peter Wahlstrom, a Morningstar equity analyst, even with underlying fundamentals that still seem positive. "It's impacting top line by between 4 percent and 5 percent for names like Oracle, IBM and even Accenture," he said.

Read MoreInside Google earnings results

The software industry as a whole is underperfoming because of currency headwinds, Scandalios said, and few if any tech investors have missed that negative trend.

Currency is not the only overseas headwind for future tech earnings. Slower international growth could further reduce earnings potential for multinationals with exposure to Europe, Japan and emerging markets. If these regions continue to have problems, then companies there may be less likely to spend on IT.

"People are concerned about those pockets of weakness," Wahlstrom said.

There's definitely a question of what's true growth right now.
Robert Breza
Sterne Agee analyst

There's so much expectation for growth around technology companies that earnings announcements, and unexpected headwinds like the huge dollar rally, can have a big short-term impact on the stock.

Investors have to resist the urge to sell a tech stock just because it missed a quarterly estimate or paid out more than expected in compensation.

Earnings brings a significant amount of volatility, so investors should take a look at these changes and decide if it's something temporary or more significant, said Robert Breza, a senior research analyst with Sterne Agee. But he added, "There's definitely a question of what's true growth right now."

It's that short-term vs. long-term horizon that Scandalios looks at when his companies run into trouble. If it looks like the miss is due to a problem that can be corrected within a few quarters, then he'll hang on to the stock. If it's clear that its three- to five-year outlook has changed, then he may sell it.

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In a sense, Scandalios has it "easier" trying to figure out what to do with Qualcomm, because the issue to analyze is acute rather than a general industry headwind causing a downward revision. Qualcomm had to revise its 2015 estimates because Samsung decided it wasn't going to use the company's semiconductor chip in its next smartphone. The chip didn't perform up to Samsung's expectations, he said.

Is that a major problem or just a misstep? That's what he's now trying to find out.

"I'm getting to the office at 5 a.m. to re-listen to the conference call. They've guided down their next three quarters. So now I'm going to talk to the company and other people to find out if they've been conservative enough. What assumptions are they making? What's really going on here?"

Where is there security in tech?

For investors seeking a safe harbor within tech amid these larger pressures, there is one subsector where the news has been mostly positive—security fraud protection, where solid earnings gains have been the rule. Check Point Software Technologies, which saw its $1.07 EPS and $421 in revenues beat analyst estimates by 1.9 percent and 1.2 percent, respectively. Fortinet, another network security firm, saw 26.3 percent year-over-year growth, while revenues beat estimates by about 6.5 percent. (Even so, these stocks have weakened since earnings—Fortinet, specifically, because it announced that it was investing more money into its business.)

"Security is getting a lot of attention," Wahlstrom said. "Whether it's customer information getting stolen or companies thinking about ways to protect their networks, it's a big theme that's mostly flown under the radar until recently."